I. Executive Summary
On 9 June 2016 the German parliament (Bundestag) passed the German Investment Tax Reform Act. The Act still requires consent of the German Federal Council (Bundesrat) but it seems likely that such consent will be granted.
The German parliament (Bundestag) passed the German Investment Tax Reform Act without substantial changes compared to the Governmental draft of such act. In the last weeks the political discussion focused on the tax treatment of certain dealings around dividend exdate. Although this matter is only partly related to the reform of investment taxation an avoidance rule for such dealings was added to the German Investment Tax Reform Act.
The reform of investment taxation, i.e. the rules for taxation of investment funds, will enter into force as of 2018. In section II below we summarized the new tax system.
Certain material changes between the drafts of the German Investment Tax Act and the law that finally passed the German parliament (Bundestag) will be set forth in section III below. Please refer also to our prior client information dated 7 August 2015 and 7 January 2016.
Moreover, section V below covers amendments to the VAT treatment of Alternative Investment Funds ("AIF").
II. The New Investment Tax Law
The German Investment Tax Reform Act fundamentally changes the German investment taxation.
1. Scope
Generally, the Scope of the German Investment Tax Act covers investment funds as such term is defined in the German Capital Investment Code. However, there are certain important exceptions:
- The most important would be that German and non-German partnerships (except for certain cases) no longer fall into the scope of the German Investment Tax Act. This means, that in particular, closed-ended fund organized as partnerships are exempted from the scope of the German Investment Tax Act. Such funds are subject to the general rules of taxation of partnerships, in particular the tax transparency of partnerships. Thus, the German tax treatment of such funds effectively remains the same as under current law.
- In addition, participation companies pursuant to the German Participation Companies Act (Unternehmensbeteiligungsgesellschaften) and German REITs and non-German REITs that are subject to the provisions of the German REIT Act are not subject to investment taxation.
This means that only corporate type investment funds will fall into the scope of the German Investment Tax Act. However, it was explicitly stated that German and non-German investment funds of a contractual type (Sondervermögen) fall into the scope.
Moreover, certain entities may also fall into the scope of the German Investment Tax Act although they do not qualify as investment funds under the German Capital Investment Code, such as:
- so-called single investor funds, i.e. investment undertakings that limit the number of investors to one single investor, but nevertheless satisfy all other requirements of an investment fund pursuant to the German Capital Investment Code;
- companies that are prohibited from making active operations pursuant to the laws of its country of residence and that are not subject to or exempted from, income taxation.
The entities that fall into the scope of the investment tax act are legally defined as "investment funds". This may give rise to misunderstanding, particularly during the transition period, as the term "investment fund" is also used but having a different meaning under the law currently in force.
2. System of Investment Taxation
Under the reform of the investment taxation there are two tax regimes available for investment funds:
- The base case is a newly introduced opaque tax regime where there are two levels of taxation: the investment fund and its investors. While this tax regime was designed for the needs of typical retail mutual funds it is, in fact, applicable to all investment funds that do not satisfy the specific criteria for specialized investment funds under the new law.
- The tax regime for specialized investment funds is based on the tax regime for investment funds under the law currently in force (cf. §1 para1b of the German Investment Tax Act).
3. Taxation of Investment Funds
a) Level of Investment Fund
Only certain specific income from sources within Germany received by investment funds are subject to tax at the level of such investment funds, in particular income from German participations (dividends) and from real estate located in Germany.
While there was a provision on taxation of capital gains from shares of German companies in the first drafts of the German Investment Tax Reform Act such provision is no longer part of the final Act. Hence, such capital gains are not taxable at the level of the investment fund to the extent they are not attributable to a permanent establishment in Germany.
The full amount of income from German participations and from real estate located in Germany and certain other German source income is subject to German corporation tax at investment fund level. In particular, the exemption for (German) dividends (§8b of the German Corporation Tax Act) is not applicable at the level of the investment fund even if the relevant threshold (10%) is exceeded.
In addition, German trade tax may be triggered at the level of the investment funds if the fund is engaged in trade or business in Germany. However, an exemption is to be available if an entrepreneurial management of the investment fund's assets is excluded. The provisions dealing with German trade tax give rise to a number of questions.
b) Investor Level
At investor level there is a lump-sum taxation which is designed for the needs of retail mutual funds with a large number of investors.
The following items are subject to tax at investor level:
- distributions;
- pre-determined tax bases (Vorabpauschalen);
- capital gains realized upon the dispositions or redemption of investment fund interests.
For individuals that hold their investment fund interests as part of their non-business assets such items are subject to flat income tax. For individuals that hold their investment fund interests as part of their business assets principally the full amount of such items is subject to income tax at their personal rate. For corporate investors the full amount of such items is subject to corporation tax. In addition, German trade tax may be triggered. The so-called partial income taxation and the exemption pursuant to §8b of the German Corporation Tax Act do not apply.
aa) Distributions and Redemptions
Under the new law repayments of capital shall qualify as taxable distributions. However, there is lack of a provision in the final Act on the deduction of the investor's acquisition cost during the liquidation process at latest. Thus, during the lifetime of an investment fund non-taxable repayments of capital may only be made by way of redemptions of investment fund interests.
ab) Pre-Determined Tax Base
The objective of the pre-determined tax base is to subject retained income of the investment fund.
The pre-determined tax base is based on the so-called base proceeds, a kind of minimum return which is determined on the base of the base interest rate pursuant to §203 para.1 of the German Valuation Act, i.e. possible long-term yield on public bonds. The base proceeds are capped at the actual increase in value of the investment fund. Moreover, the pre-determined tax base is equal to the difference between the base proceeds and the actual distributions.
The pre-determined tax base is deemed to be received by the investor in the immediately following calendar year. Hence, the possible dry income issues may be avoided (fully or partially) by a well-directed distribution policy.
ac) Partial Exemptions
Investment fund proceeds (i.e. distributions, pre-determined tax bases, capital gains from dispositions or redemptions) are subject to partial exemptions depending on the respective fund type:
- with respect to equity funds
(Aktienfonds) the partial exemption is as follows
- for individuals that hold their investment fund interests as part of their non-business assets 30% of such proceeds;
- for individuals that hold their investment fund interests as part of their business assets 60% of such proceeds;
- for corporate investors 80% of such proceeds.
- With respect to so-called mixed funds (Mischfonds) half of the partial exemption rate applicable to equity funds (Aktienfonds) is available. Mixed funds are investment funds that invest at least 25% of their value in equity participations.
- With respect to real estate funds – i.e. investment funds that invest at least 51% of their value in real estate and real estate companies – the partial exemption rate is 60% of the proceeds. If a real estate fund invests at least 51% of its value in non-German real estate and non-German real estate companies the partial exemption rate is 80% of the proceeds.
4. Specialized Investment Funds
The tax regime for specialized investment funds can be considered a continuation of the tax regime for investment funds under the law currently in force (§1 para.1b German Investment Tax Act).
To qualify as specialized investment fund an investment fund must satisfy certain criteria with respect to regulation, redemption rights, eligible assets and investment restrictions. These are substantially similar to the criteria under the law currently in force. However, there are certain specialities with respect to the definition of securities (see below).
Moreover, a specialized investment fund may – like under the law currently in force – have 100 investors at maximum. Unlike the law currently in force there is a look-through approach with respect to partnerships as investors, i.e. each partner of such partnership is counted as one investor of the investment fund.
Under the new law individuals may invest directly in a specialized investment fund, provided that they hold their specialized investment fund interest as part of their business assets. This is new compared to the law currently in force and the first drafts of the German Investment Tax Reform Act.
As a base case specialized investment funds are subject to the general tax rules for investment funds described below. However, they may opt for a semi-transparent tax regime which is the one known under the law currently in force. However certain amendments have been made to this system in the course of the investment tax reform.
5. Tax-exempt Capital Gains
In recent year there was an ongoing controversial discussion to abolish the exemption for capital gains from the sale or disposition of shares in a corporation (§8b para.2 German Corporation Tax Act) in cases of shareholdings of less than 10%. While there was a respective provision in the first draft of the German Investment Tax Reform Act such provision was not part of successor drafts and the final Act.
Thus, such capital gains remain tax-exempt in the future irrespective of any ownership percentages. However, it cannot be fully ruled out that this matter will be subject to discussion again, in particular after the Federal Election in 2017.
III. Further Changes During the Legislative Process
The following section provides an overview on certain material changes between the drafts of the German Investment Tax Act and the law that finally passed the German parliament (Bundestag). Reference is also made to our prior client information dated 7 August 2015 and 7 January 2016.
1. No CFC/PFIC Taxation
While there were no explicit provision in prior drafts it was common sense that CFC/PFIC taxation under the German Foreign Tax Act is not applicable on investment funds. There is a provision in the German Foreign Tax Act that provides that in cases of investment funds the provisions of the German Investment Tax Act prevail. Moreover, unlike the law currently in force (cf. §19 para.4 of the German Investment Tax Act) there is no provision in the new law that makes an exception to this rule.
Nevertheless, in the final Act it is clarified that the provisions of the German Investment Tax Act prevail because certain technical amendments were made to the provisions of the German Foreign Tax Act without doubting the general rule.
2. No Partial Exemption for Investment Fund Interests Held for Trading
Similar to the partial income taxation the and corporation tax exemption for dividends and capital gains the partial exemption for equity funds (Aktienteilfreistellung, see above) is intended to reflect any taxation of the company at the level of its shareholder. However, the corporation tax exemption is, inter alia, not applicable for life and healthcare insurance companies (cf. §8b para.8 German Corporation Tax Act). Accordingly, the partial exemption for equity funds was not available for life and healthcare insurance companies under the prior drafts.
The corporation tax exemption pursuant to §8b of the German Corporation Tax Act and the partial income taxation are also not available for shares held for trade by banks and financial institution and financial enterprises that acquired shares with the objective to achieve a short-term gain. Now, the final Act provides that partial exemption for equity funds (Aktienteilfreistellung) is also not available for these types of investors.
I. Changes with Regard to Specialized Investment Funds
As provided in prior drafts, a modification of semi-transparent taxation will continue to be applicable for specialized investment funds also post-2017. In addition to certain qualitative and quantitative restrictions regarding eligible investors, a classification as specialized investment fund depends on the applicability of, and compliance with, certain product rules. These product rules have been modified in the final Act.
1. Re-introduction of Manager Principle
Classification as a specialized investment fund requires that the fund is subject to investment regulation. In deviation from what applies under the law currently in force, a prior draft provided that the fund vehicle itself had to be subject to investment regulation. According to the final Act, the regulation requirement is met if either the fund or its manager is subject to investment regulation. Therefore, for instance the following structures can qualify for treatment as specialized investment funds:
- specialized investment funds under the Luxembourg Law of 13February 2007, whose managers are not authorized pursuant to AIFMD; and
- unregulated Luxembourg funds which are managed by a manager authorized under AIFMD.
2. Modifications Regarding Assets Eligible as Securities
The criteria for specialized investment funds contain an exclusive list of eligible assets in which 90% of a fund's NAV must be invested in order for the fund to qualify as specialized investment fund. The previous draft had contained a security definition which was in line with the definition of transferable securities under the UCITS Directive.
In the final Act the definition of "security" has been extended to cover other assets which are eligible to be acquired by UCITS up to 10% of their net asset value. This includes transferable securities pursuant to Directive 2007/16/EC ("Eligible Assets Directive") even if they are not listed. However, the 10% limitation does not apply for purposes of the criteria for specialized investment funds.
Based on the official reasoning it seems that the new definition, deviating from the so far applicable economic security definition, is supposed to be exhaustive in order to avoid indirect investments (e.g. using securitization vehicles) in assets which do not comply with the criteria for specialized investment funds. This statement gives rise to questions and is not quite comprehensible to us, since securitization vehicles typically issue securities. Until the legislator or the tax authorities release a desirable clarification, there is a legal uncertainty in connection with private equity and other closed-end fund products structured as investments in securities.
3. Requirements for Participations in Other Investment Funds
The final Act contains further modifications with respect to the eligibility of participations in other funds. Generally, interests in funds may qualify as investment fund interests, as securities, or as participations in corporations. Certain limitations which apply to securities or participations in corporations will not apply if classification as an investment fund interest is possible. In contrast to the previous draft, the final Act does not exclude participations in open-ended retail funds from qualification as investment fund interests. However, also contrary to the previous draft, target funds and their managers must be subject to an investment supervision.
IV. Value Added Tax
In its decision dated 9December 2015 (C-595/13; Fiscale Eenheid), the European Court of Justice ("ECJ") has held that the management of real estate funds that are subject to specific state supervision is VAT exempt according to Article13B(d)(6) of Directive 77/388/EWG (now Article135(1)(g) of the Directive on the Common System of Value Added Tax, "VAT Directive").
This decision has a direct impact on other types of funds including German closed-ended AIF such as private equity funds (cf. section 1 below). The adaption of the German VAT law which has definitely become necessary due to the decision has been made by the German Investment Tax Reform Act; it is doubtful whether this adaption is sufficient (cf. section 2 below).
1. Consequences of the Decision
Unlike in the most EU member states, the management of closed-ended AIFs (such as private equity funds) is not VAT-exempt in Germany. This is due to the fact that Germany interprets the VAT exemption granted by the VAT Directive for "the management of special investment funds as defined by Member States" very narrowly. The German legislation transposing this VAT exemption into national law (Sec.4(8) lit.h) German VAT Act) is limited to investment funds (Investmentfonds) within the meaning of the German Investment Tax Act currently in force (i.e. basically UCITS and open-ended real estate funds).
Based on the ECJ's reasoning, closed-ended AIF that are subject to the regulation under the German Capital Investment Code (i.e. the German AIFM law) must be granted the VAT exemption. The same should apply to AIFs or AIFMs which are subject to the EuVECA Directive (i.e. a distinct extensive supervisory regime).
Based on the reasoning of the ECJ the decisive point is that the power of the Member States to define the investment vehicles that fall into the scope of the exemption under the VAT Directive is superseded by the harmonized European regulatory law. Accordingly, not only UCITS fall within the scope of such exemption but also AIFs. The latter are comparable to UCITS if and because they are regulated.
2. Adaption by the German Investment Tax Reform Act
The German Investment Tax Reform Act provides that the management of UCITS and AIFs that are comparable to UCITS is VAT-exempt as of 1January 2018.
While the law itself does not elaborate the criteria that have to be satisfied for an AIF to be comparable to UCITS such criteria are set forth in the (non-binding) official reasoning of the German Investment Tax Reform Act. Under such criteria an AIF, inter alia,
- must be subject to a comparable regulation like UCITS and
- must have the same types of investors like UCITS.
As discussed at least BaFin regulation under the German Capital Investment Code or EuVECA should be comparable in this regard. There may be doubt whether so-called subthreshold specialized AIFMs and "small" retail AIFMs (§2 para.4 and 4a of the German Capital Investment Code) and AIFM of retail AIFs (§2 para.5 of the German Capital Investment Code) are subject to a special regulation such that the management of such AIFs is VAT-exempt. However, to strengthen the fund industry in Germany and for systematic reasons we hope that this question will be affirmed.
Another problem is that the official reasoning of the German Investment Tax Reform Act requires that AIFs must have the same types of investors like UCITS to benefit from the VAT-exemption. If this referred to retail investors this would not be covered by decisions of the ECJ. Moreover, even under current law the majority of VAT-exempt investment funds are specialized investment funds having institutional investors. However, based on the official reasoning the intention is that such specialized investment funds are nevertheless to benefit from VAT-exemption in the future.
Unfortunately, the amendments to the German VAT Act shall enter into force on 1January 2018. Given that the law currently in force is not in line with European law the amendments should enter into force immediately.
Hopefully, the legislation and/or the tax authorities solve any of these outstanding issues and amend the law where needed.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
